Shortly after the New World was discovered, a race ensued by explorers to stake their claim for their king, their homeland and themselves. The fleets that these explorers sailed across the sea represented the finest engineering of the day, and the crews were some of the best trained in the world. However, despite the cutting-edge design and immense resources invested in this effort, many ships found their way to the bottom of the Atlantic, along with their gold and crew.
Even with the most advanced tools made available to these adventurers and merchants, the broad swath of the stormy Atlantic was unlike anything the captains had seen. In short, they failed to recognize a changing nautical environment and adapt accordingly.
Today, trillions of dollars in currencies and equities represent a sea of opportunity on a global level, and individual traders are the captains trying to navigate the undulating planes for profit and reward. Unfortunately for many, the risk is too much and their adaptations too slow, so they find themselves in the financial version of Davy Jones’ Locker.
In the late 1990s, the dot-com era was in full bloom, with a record number of breakout stocks that were riding the crest of the Internet frenzy. Momentum trading was all the rage. Traders simply would wait for a breakout, buy and hold on. Substantial profits by mid-day were common.
The profits attracted a lot of money to the stock market, both from new investors and traders as well as additional investment from existing market participants. For many, the dot-com surge was an investor’s Golden Age. Many even borrowed additional cash to invest, thinking that it would never end.
But end it did.
Eventually, a financial bubble formed, followed by a bust in early 1999. The effects of the collapse in many ways still are being felt today. One effect has been a long-term shift in the market’s personality. Breakouts have dried up or failed to materialized. What worked in the late 1990s, no longer makes money. Traders who continued to bet big in old familiar ways faded into financial obscurity as their accounts dwindled.
In some ways, current markets mimic the sideways torment of the 1970s, when stock market profits were hard to come by and breakouts failed to provide easy money (see “Sideways seventies,” below).
The reason so many speculators crashed and burned after the Internet bubble burst is they didn’t understand the importance of market types. What works during a parabolic market move, won’t work when the parabola turns downward. Unfortunately, many traders didn’t recognize the turn, or the sideways market that followed (see “Breakout!” below).
If more traders understood this concept, and reacted, they might have avoided the crash and instead adopted or developed tools that would have made money as prices churned.
But you can’t blame your average trader for missing the clues. We typically think of markets as “up” or “down” entities, with little consideration for time frame or directional movement across periods. This brings us to an important concept in recognizing the operative state of the market. If you change your point of reference, price trends take on a whole new shape.
Time periods generally are defined as follows:
- Long-term: A period of months to years.
- Intermediate-term: A period of weeks to months.
- Short-term: A period of minutes to days or weeks.
A critical rule when using time periods is that the larger time frame has dominance over the smaller time period when defining primary price movement.
So, by understanding time periods, you can define the period of price action to determine which market-type is in play. They are, simply: Up, down or sideways. Once you properly can identify the market type, you can tailor your approach for higher performance.
Warren Buffett’s style of value investing — described as “selective contrarian investing” in “The New Buffettology” — focuses on not just buying a stock on valuation but instead actively exploits bear markets as primary buying opportunities. For Buffett, the shift to a down market is a key setup for bargains to ultimately materialize. This market type is an important condition for maximizing returns.
Types and tools
Once you have defined your time frame, you can identify the current market type by using a simple set of moving averages. These will act as a representation of price.
By combining a 20-day simple moving average and a 40-day simple moving average, you will have a powerful pair that can indicate price directional bias and reveal the current state of the market. The following are typical interpretations of these indicators:
- The market-type is bullish when the 20-day simple moving average is trading above the 40-day simple moving average.
- The market-type is bearish when the 40-day simple moving average is trading below the 20-day simple moving average.
- The market-type is sideways when both simple moving averages are moving sideways with no constructive movement in either direction, up or down.
These simple moving averages and rules apply to all time frames regardless of the time period. In technical terms, the time period is the parameter you define, while the simple moving averages are the filters you employ.
In addition to defining the market type of your primary time period, you also will want to make note of the market type of the time period one step higher. You will want both periods to align before you shift your bias. Likewise, once that bias has been set, constantly monitor both periods and once either breaks, prepare to transition from one market type to another. This preparation might involve liquidating positions, tightening stops or employing protective options strategies depending on your personal approach.
Keep in mind, however, that the shorter time period will lead the simple moving averages on the longer time period. However, this doesn’t necessarily mean that the two always will move in lock step. For example, the shorter time period might reverse temporarily before the longer time frame catches up.
For most traders, a shift in market bias is a signal to step back and reassess. However, aggressive traders will pounce on the market reversals — those that can appear at the point where market types shift — that can generate significant profits. Most styles, however, are more conservative and benefit from patience, consistency and caution. As with all strategies, approach market type changes in a way that is consistent with your risk tolerance; otherwise, you may lack the discipline to follow your strategy.
The ability to adapt to the market environment is necessary for financial survival. Fortunately, this is not a difficult task, but like most trading rules, it’s important to follow it consistently and precisely. Avoid over-complicating your analysis of the current state of the market. The rules reviewed here are a simple and effective approach and provide a clear visual signal of whether the market is moving up, down or sideways.
Billy Williams is a 20-year veteran trader and publisher of www.StockOptionSystem.com, where you can read his commentary and a report on the fundamental keys for the aspiring trader.